Learning Centre
The Three Major Financial Statements: Why Do They Matter?

The Three Major Financial Statements: Why Do They Matter?

Financial statements... two words many entrepreneurs are afraid of. Banks and funders — such as the Land Bank or the Industrial Development Corporation of SA (IDC) — require both historical and projected to assess your past performance and the future viability of your project. In short, can you repay the money you are looking to borrow?

What are those financial statements? Why do they matter? Let's unpack these questions. 

The Balance Sheet

It displays your company's total assets and how they are financed, through debt or equity. The balance sheet is based on the fundamental equation: Assets = Liabilities + Equity.

The balance sheet's left side outlines a company's assets. On the right side, the balance sheet outlines the company's liabilities (i.e. what you owe) and shareholders' equity (the value of the shareholders’ stake in the company).

The assets and liabilities are separated into two categories: current assets/liabilities (short-term) and non-current (long-term) assets/liabilities. 

👉 Why does it matter?

  • The balance sheet informs you about how much the company is worth from a book value perspective. 
  • Lenders will use many ratios to test the financial fitness of your company and the risk of lending to your company, such as debt-to-asset or debt-to-equity.

The Income Statement or the Profit & Loss (P&L)

The Income Statement shows a company's profit and loss over a period of time. The profit or loss is calculated by summing up all revenues and subtracting all expenses from operating and non-operating activities.

The Income Statement usually contains the following items (in descending order):

  • Revenues or sales - associated with selling your goods or services;
  • Cost of Goods Sold (COGS) or Cost of Sales (for service companies) - aggregates all the direct costs associated with creating the goods sold or providing services. It usually includes expenses such as labour, inputs, seeds, packaging, etc.
  • Gross Profit = Revenues / Sales - COGS / Cost of Sales
  • Indirect Costs - a company's fixed costs related to marketing, selling, general, and administrative expenses
  • EBITDA (Earnings before Interest, Tax, Depreciation, and Amortisation) = Gross Profit - Indirect Costs
  • Depreciation & Amortisation Expense - non-cash expenses that are created by accountants to spread out the cost of capital assets such as equipment, tractors, and other vehicles
  • EBIT or Operating Income = EBITDA - Depreciation & Amortisation Expense
  • Interest - which may include interest income (e.g., if you place your cash in savings accounts) and expense (e.g., if you raise debt from a bank and pay interest) 
  • EBT or Earnings Before Tax = EBIT - Interest
  • Income Tax - SARS will charge a corporate income tax rate on your profit
  • Net Income = EBT - Income ... your actual profit at the end of the year

👉 Why does it matter?

  • The Income Statement provides lots of information on your company and its profitability
  • To assess your company's profitability and test your ability to repay a loan, lenders will analyse ratios such as the gross margin, operating margin, or interest coverage

The Cash Flow Statement

This is often the most important to manage your company day-to-day. It demonstrates your company's overall liquidity by showing cash transaction activities. Put simply if you don't have the cash to pay your expenses or debt when owed, even if your business is profitable, your company may go bankrupt.

This statement is usually broken into three parts:

  • Operating CF - is the net cash in- or outflow you make from your operations derived from your sales and expenses
  • Investing CF - shows the cash in- or outflow from the purchase of assets and the (potential) gains from resold assets
  • Financing CF - is linked to financing your operations (e.g., with a production loan) or your investment (e.g., with a mortgage for a property). It shows the net cash in or outflow from raising or paying debt or raising or paying cash to shareholders.

👉 Why does it matter?

  • It determines your company's liquidity, and when projected in the future, it may indicate when it may run short of cash to pay its expenses and debt commitments
  • It is used by lenders to test your need for cash and your ability to repay debt at any point in the future